Stress Test: Will These Telecom Dividends Survive?

The earnings results of Frontier Communications (NYS: FTR) and other telecommunication companies lately have been grim. Yet amid the rush to get out of these stocks, Wall Street has pushed dividend yields on many of these companies to between 8% and 16%. That makes telecom companies some of the highest income-paying stocks on Wall Street today. The critical question is this: Can these dividends last, and will these companies be able to hold off the onslaught of falling revenues, burdensome debts, and increasing competition? With a little bit of analysis, I believe our answer is yes.

That may be welcome news for investors in these stocks. Frontier Communications is now down 45% for the year, and more generally, shares of the largest players have declined from 20% to 50%. Cable companies have similarly underperformed. As you will see, the time may be right for calling the bottom.

What Frontier's third quarter revealedFrontier's recent earnings report brought a piece of bad news. Revenues descended yet again, falling sequentially by $31 million to $1.291 billion. The pressure on results comes from a consumer voice business that is clearly in decline. Homes are increasingly cutting their first and second phone lines in favor of solely mobile devices, and since just the beginning of 2010, Frontier access lines are down by 18%.

The company has taken the brunt of the pain, and Frontier's remaining business increasingly serves business, wireless, and broadband needs. In fact, 51% of customer revenue now comes from business clients and 13% comes from residential high-speed Internet. Arguably, 10% more of its revenue is rather sticky, since these are residential customers who have phone lines with high-speed Internet or satellite packages.

What remains is just 26% of customer revenue that is "at-risk," and here's the thing: If this amount was entirely wiped out and nothing else happened, free cash flow would still be $176 million per year. And more realistically, there are two reasons that analysis is too bleak.

First, although one-third of revenue could possibly be dwindling, the other two-thirds of the business has a brighter future, with prospects tied mostly to business and data needs.

Second, debt costs are coming down. Frontier's effective interest rate on its $8 billion in debt is about 8.3%, yet recently, the company refinanced $575 million of debt at effectively 3.13%. That move alone will save Frontier $25 million per year, and if Frontier gets its leverage ratio down, the interest expense will drop by another 1%.

The Foolish bottom lineThe results seem to suggest that both telecom and cable are misunderstood. So which of the two is the better bet?

Turns out the valuations for rural telecom and cable competitors are rather similar. The superior choice really depends on your perspective. On the one hand, rural telecom companies have a large exposure to the landline phone business. On the other hand, they face relatively little competition in their markets, and some earn a majority of their revenue from safer business and broadband sales. With cable companies, you get a business that is growing but that also earns the majority of its revenue from providing residential video services. If you believe that the Internet may disrupt the television business anytime soon, then you can argue that telecom is the safer bet. Better to stick with the devil you know.

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